27 September 2008
Deregulation as a Scapegoat
I do want to take a look at the notion, though, broached by Obama, that "deregulation" is the cause of the present Wall Street crisis. I think that a mistaken diagnosis, and reform instituted on such a premise will likewise be mistaken.
The current Wall Street crisis appears to have taught many of our nation’s politicians that every important piece of financial deregulation in the last thirty years has been an error. In this scramble to ‘learn from our mistakes,’ each of several measures – each blameless, and each indeed a forward step for the U.S. and world markets – has come under fire.
I refer for example to: the securitization of mortgages; the abolition of the walls that for decades kept commercial banking apart from investment banking, and that kept both sorts of banks isolated from insurance companies; the exemption of over-the-counter derivatives from a regulatory system designed for standardized exchange-listed products; the abolition of the uptick rule. Of those changes only one, the the abandonment of the uptick rule, can be blamed upon -- or credited to -- this administration. These are all the new “usual suspects,” rounded up when something has gone wrong in “Casablanca.”
In order to think straight about such matters, we might begin by abandoning the label “subprime crisis." Yes, subprime mortgages are inherently risky. That's what the word "subprime" means, after all: more risky than prime. The current troubles may early on have taken the form of a subprime problem, but if it had been only or chiefly that they would have long since have settled down.
What we have is the aftermath of a credit bubble. That bubble burst, which is what bubbles do. The bursting in turn caused an equity bubble to do likewise, because the equities are so leveraged. That, in turn, is inspiring moronic socialistic moves by alleged free marketers.
One key lesson is never learned, however often this sort of drama plays out: that what causes a bubble to burst is precisely the fact that it has been blown. The seeds of the bust are always planted by the boom. Only in October weren’t some of the administration’s admirers complaining that it wasn’t receiving enough credit for the record-high stock market index figures of that time? The Bushies should get exactly as much credit as they are willing to shoulder blame: because the Dow 14,000 of October is one facet and the Dow 11,000 of the following September is another facet of the same fact, the fact of boom-bust psychology.
Question: what is it that markets are good at?
Answer: aggregating information. Any price (whether the price of a barrel of crude oil, a newly manufactured pencil, or a share of equity in a corporation) expresses information. It either does so accurately (and keeps the whole productive system humming) or it does so inaccurately (and throws sand into its gears).
Leonard Read’s famous 60-year-old fable about the price of a pencil makes this point marvelously well.
Let’s observe, while we are so close to the point, that the Securities and Exchange Commission’s decision to impose an emergency ban on short selling was idiotic. Capital markets are obviously less efficient without shorting than they are with it, simply because shorts bring information to the table.
At any rate, every one of the deregulatory moves listed above was a good idea, one that smoothed the flow of information into prices, and so assisted the optimal alignment of incentives throughout the economy.
The risks inherent in subprime mortgages, and in the instruments built from them, are in principle familiar and manageable. Why have they not been managed? Because there are a lot of new restraints on the free flow of information that impeded that risk management task. None of these restraints by itself would have been disastrous, but they’ve had a cumulative effect. Consider the condition of an artery near the heart of an over-eater. It is hard to say which donut is fatal. But in sum, they are. They create the arterial gunk that will block the flow of vital blood/oxygen/information to tissue that needs it.
Gordon Crovitz had a fascinating op-ed piece on this subject in Monday’s [Sept. 22]Wall Street Journal, under the headline, "Information Haves and Have-Nots."
The money quote. "There are now about half as many Wall Street analysts as in 2000. Former New York Attorney General Eliot Spitzer eviscerated the profession with $1.4 billion in settlements and a new mandate for how the industry would be structured, which made the analysts uneconomical....The now-former senior executives at Bear Stearns, Lehman and Merrill must wish they had been able to retain all those star banking analysts."
Another Spitzer legacy that has contributed to our present troubles was his Ahab-like pursuit of Hank Greenberg, effectively kicking him out of the executive suites of the insurance company Greenberg did so much to build -- AIG.
Other issues that contributed to the crisis: a ramping up of insider-trading prosecutions (including a perp walk for Ralph Cioffi and Matthew Tannin in June). The people who are deterred from trading by insider trading prosecutions are being who are … the best informed. The whole idea of criminalizing such trades strikes at the heart of the real function of markets.
Further, there is room for concern that the federal bankruptcy courts have become part of the problem. This March, Judge Posner, of the 7th circuit court of appeals, suggested that bankruptcy trustees need to be reined in, writing: “While the management of a going concern has many other duties besides bringing lawsuits, the trustee of a defunct business has little to do besides filing claims that if resisted he may decide to sue to enforce.”
In particular, trustees have become quite aggressive of late in pressing claims for fraudulent conveyance. The result is that counter-parties to any institution that may even be close to bankruptcy, which may even be rumored to be close to bankruptcy, have gotten very jittery. Why set one’s self up to be the defendant in a lawsuit brought by the next aggressive trustee?
It is a legal climate that encourages “runs on the bank,” and that is what we have gotten.
So the right lessons to draw emphatically aren’t lessons about how deregulation has “gone too far.” Nor are they lessons about the GSEs, or about the greedy golden-parachute-endowed CEOs.
No. The right lessons to draw are that the information arteries in the U.S. market system have become clogged, and after the immediate crisis has passed, the U.S. will have to take up a new metaphorical diet to keep that from happening again.
In the meantime, though: what is to be done? How can the immediate situation best be addressed?
I'll have something to say under that heading tomorrow.
Knowledge is warranted belief -- it is the body of belief that we build up because, while living in this world, we've developed good reasons for believing it. What we know, then, is what works -- and it is, necessarily, what has worked for us, each of us individually, as a first approximation. For my other blog, on the struggles for control in the corporate suites, see www.proxypartisans.blogspot.com.